Contemporary Models of
Development
Contemporary Models
• These theories highlight the fact that development is
much harder to achieve than had been previously
thought.
• The new models incorporate:
– Coordination problems
– Alternative market structures
– Increasing returns to scale
– Imperfect Information
– Multiple Equilibria
– Externalities
Endogenous Growth Models
– According to traditional models, in the
absence of external shocks and
technological change, all economies will
converge to zero growth. This leaves no
explanation for sustained growth. All
unexplained growth is attributed to the
Solow Residual. Growth for the most part is
the result of an exogenous process. It is
impossible to analyze the determinants of
technological change.
• New growth theory provides a framework for
analyzing persistent growth in national income
that is determined within the system rather than
by external forces.
• Exogenous changes in technology still play a role
but they are no longer needed to explain long-run
growth.
• Explain growth rate differentials across countries
• Explain a greater portion of the growth observed
New growth theory
• GNP growth is determined by the system
governing the production process rather than
by forces outside that system
• Endogenous growth theorists seek to explain
the factors that determine the size of Solow
residual
• Discarding the assumption of diminishing
marginal returns to factors introduced the
assumption of increasing returns to scale
• It assumes that investments in human capital
generate positive externalities and result in
increasing returns
• creativity is the expression of mind power: It is
the capacity to produce new ideas such as
inventions and innovations and creativity is
the main driver for economic development.
• Investment in knowledge and R&D is a kind of
capital and is not subject to diminishing
returns. The new growth theory assumes that
people invest in human capital which results in
inventions and innovations in turn increases
the level of consumption and investment
• The model may be explained as
• Yi =AKiαL 1-αK β
There is assumption of symmetry among
industry so each industry will use the same
amount of capital and labor then we have
aggregate production function
Y = AKα+β L1-α
Where A represents technology and assume that
there is no technical progress over time
• With a little calculus it can be shown that the
growth rate for per capita income is
• g- n = βn/ 1-α-β
• If βn is positive ( human capital) then growth
rate is greater than n and if βn is zero this
growth rate is equal to n like in Solow model
Criticism of New Growth Theory
• It either assumes a single sector for production or
that all sectors are symmetrical, not allowing for
growth-generating reallocation of labour and capital
between sectors that are transforming due to
structural change.
• Overlooks inefficiencies brought about by poor
infrastructure, inadequate institutional structures
and imperfect capital and goods markets.
• Since the focus is on steady-state growth rates, the
theory places most of its emphasis on explaining
long term growth rates and not on short or
medium-term growth
Underdevelopment as a Coordination Failure
• Complementarities are present when an action
taken by one agent increases the incentives for
other agents to take similar actions. The
decisions are mutually reinforcing.
• A coordination failure occurs when agents’
inability to coordinate their behaviour results
in an equilibrium that leaves all agents worse
off than in an alternative equilibrium.
Coordination failure models highlight the fact that in order to
get sustainable development underway, several things must
work well enough simultaneously.
In order for investment to be profitable for an individual
agent, a significant number of other agents must undertake
investment.
Whether we are in advanced capitalist economies or in
traditional subsistence developing economies, we will find
many examples of this circular causation of positive feedback.
The inability to coordinate investment efforts can leave an
economy stuck in a bad equilibrium. Often coordination
problems are exacerbated by other market failures such as
those affecting capital markets.
• Underdevelopment trap
• A region remains stuck at the subsistence level
due to coordination failure. No one invests in
new products or skills because the demand is
not there. The demand for new products and
skills is not developed because the new
products and skills are not available
• Role of Government
• Clearly there is a role for government in coordinating
joint investments. Often there is a lag between making
the investment and the realization of the return. So
each agent waits for someone else to make the first
move and a bad equilibrium results. Deep government
intervention is needed to move the economy to the
preferred equilibrium. On the other side, bad
government policy could result in the economy
moving to a bad equlibrium
• Underinvestment in New Technologies
• This is another example of coordination
failure. The benefit to adopting a new
technology for an individual firm is contingent
on the adoption of this technology by other
firms, so each firm invests less than the
socially optimal level
• Joint Externalities
• Normally in economics we think of self-interested
individuals responding to incentives such as market prices in
order to determine their actions. These mechanisms impose
counter-pressures in order to restore balance. Often in
development economics, joint externalities in which
behaviour is mutually reinforced exist so that a state of
underdevelopment results in further underdevelopment,
while on the other hand, processes of sustainable
development, one underway, tend to beget further
development.
Coordination Game
– Many wireless phone providers have calling plans in which
calling someone with the same wireless plan or on the
same network is costless to the consumer. It is also very
costly to switch wireless providers.
– It would be beneficial to an individual wireless consumer if
all of his friends and relatives were on the same network.
The larger the number of people on the network, the
larger the savings.
– It would be socially improving if everyone could find a way
to coordinate their wireless provider decisions.
Multiple Equilibria
Multiple Equilibria: A Diagrammatic
Approach
• Generally, these models can be diagrammed
by graphing an S-shaped function and the 45º
line
• Equilibria are
– stable when the function crosses the 45º line from
above
– unstable when the function crosses the 45º line
from below
Multiple Equilibria
• In above mentioned diagram we suppose that
X-axis shows the number of friends expected
to sign up for an instant messaging service
while Y-axis show how many will sign up.
• Some people might sign up even none of their
friends sign up. It give positive intercept on Y-
axis but after that the slope of the curve is
positive as more friends expected to sign up
more there will be who want to do so.
– Starting out of equilibrium, the expectations
adjustment process would continue until
agents observe what they expected to see.
– An equilibrium is stable if when we start
slightly away from it, the adjustment
process brings us back to that equilibrium
– An equilibrium is unstable if starting slightly
away from it, pulls us further away from it.
The Big Push
• Market failures make initializing growth
difficult.
– Low initial demand
– High set-up costs
– Increasing Returns to Scale
– Spillovers and underinvestment
– A concerted economy-wide effort is needed.
Model
• One factor of production, Labour (L), is in fixed
supply
• Wage in the traditional sector is assumed as 1
wT = 1. T represent traditional sector
• Workers in the modern sector receive a wage
wM > 1.M represents modern sector
• N types of products are produced, where N is a
large number
• In the traditional sector, constant returns to scale
while in modern sector increasing returns to scale.
one worker produces one unit of output in
traditional sector. At least F workers are employed
to produce output in modern sector.
• Labour Required in traditional sector: LT=QT
• Labour Required in modern sector: LM = F + cQM
• c is the marginal labor required for an additional
unit of output. c <1, reflecting the higher
productivity of workers in the modern sector.
• Average cost is decreasing in output in the modern
sector , while it is constant in the traditional sector.
• Cost and Average cost in the traditional sector:
• CT = wTLT(QT) = QT ACT=1
• In modern sector
• CM = wM[F + cQM] ACM= wMF/QM + wMc
Consumers spend an equal share of national
income on the consumption of each good, so that
domestic demand for the output of the
traditional and modern sector is Y/N.
A assumed perfect competition in traditional sector
means P= MC so that PT = MC(QT) = 1.
At most one firm can enter each market of the
modern sector due to increasing returns to scale in
production – (natural monopolies). Competition
from the traditional sector forces .The monopolist
in the modern sector charges a price not more than
1 due to competition by traditional sector
As wages in other sectors are 1 and only one
modern firm enters in the market so there is no
change in National income which results in low
demand
Whether or not entry occurs depends on how much more
efficient the modern sector is and how much higher the
modern sector wage is relative to the traditional sector.
With relatively low modern wages it is profitable for a firm
to enter in modern sector. If many firms enter in different
sectors labor earn high wages and can purchase increased
production. The whole economy will industrialize. Demand
is now high enough that we end up with point B in each
sector
The Big Push
Multiple Equilibria and Coordination Failure
– Incumbency and Barriers to Entry
– Behaviour and Norms
– Linkages
– Inequality and Capital Market Imperfections
Incumbency and Barriers to Entry
• Sometimes due to the advantages of
incumbency, new firm with more productive
technology is discouraged from entry.
Incumbents are able to take advantage of
increasing returns to scale in their own
production processes, with lower average
costs at higher output levels due to
established and large markets for their
products
• New entrants face large fixed costs at the
beginning and initially small demand for their
products. With increasing returns to scale they
start out with higher average costs and are not
able to price competitively with the
incumbent and so entry is not attractive
Behaviour and Norms
• Sometimes the incentives provided by social
norms and even laws and regulations reward
dishonest and corrupt behaviour, driving out
honest efforts.
• Removing social norms that encourage bad
behaviour or creating social norms that
encourage good behaviour can themselves be
subject to coordination failure
Linkages
• Backward Linkages raise demand for an activity
• Forward Linkages lower the costs of using an
industries output
• When certain industries are established first,
their linkages with other sectors can facilitate the
development of new industries.
• Target investment in key industries with strong
linkages that are less likely to be draw private
investment
Inequality and Capital Market Imperfections
• The traditional view is that a small amount of
inequality is needed to enhance growth because
some funds need to be pooled in order to increase
savings and investment.
• However, high inequality could retard growth as the
inability to access credit markets due to lack of
collateral is part of the definition of poverty. Too
few people have the ability to become
entrepreneurs because of imperfect credit markets
and the indivisible nature of some of the
investments
Kremer’s O-ring Theory
• Attempts to explain the existence of poverty
traps and why countries caught in poverty
traps can have such extremely low incomes
compared to richer countries.
• Features Strong Complementarities in
production which results in the positive
assortative matching of the factors of
production by productivity.
• Production of a single product is broken down into n
tasks.
• 0 < qi < 1, is the skill level with which each component
is produced. qi can be interpreted as a measure of
quality of the component or the probability that the
component will function properly.
• The total quality of the final product is given by
multiplying the quality of the n components.
Y = q1 x q2 x q3 x…x qn
• Firms are risk-neutral
• Labour markets are competitive and labour supply is
inelastic
– So, workers are paid according to their productivity.
• Strong complementarities in production
• Workers are imperfect substitutes for each other.
• Closed economy (inputs cannot be imported)
Positive Assortative Matching
• High productivity firms have the means to
attract high productivity workers.
• High productivity workers prefer to work with
high productivity firms because their pay is
based on how productive they are and their
productivity is affected by the skill level of the
workers around them
• So all the high productivity workers will be
grouped together, leaving the low productivity
workers to work with other low productivity
workers
• It is also socially efficient to group workers
together by productivity
– Suppose that there are 4 workers producing
two components to the production of a
product and also two types of workers – low
productivity workers with skill level qL and high
productivity workers with skill level qH.
So Y = q1q2
– Output is higher if we group the workers by
skill
qH2 + qL2 > 2qHqL
Implications
• Firms tend to employ workers with matching
skill levels
• Income is higher for workers in higher-skilled
firms so all workers prefer to work in higher-
skilled firms
• Wages increase at an increasing rate in quality,
explaining the large disparity between wages
in developed and developing countries
• Individual decisions to invest in training and
education are based on the average skill level of
others around you. Multiple equilibria can exist in
which everyone invests at a high level or in which
every invests at a minimal level leading to lower
product quality. Strategic complementarities can
result in low-skill equilibria
• An industrial policy to promote economy-wide
quality improvement could result in tremendous
growth
• O-ring effects magnify the impact of local production
bottlenecks which reduce the incentive of workers to
invest in skills.
• International trade and investment could improve
product quality with the importation of higher-quality
inputs and high-productivity technology.
• When the availability of high-skilled workers is limited,
firms will choose less complicated technology and
specialize in the production of simple goods. Large
firms that specialize in complex products place a
premium on high-quality, skilled workers. So the model
has predictions on choice of technology given the
available skill level.
• The model can also explain international brain
drain as highly-skilled workers in developing
countries emigrate to developed countries
where they can receive higher wages for their
skills.
